Chapter 1 end of chapter key

1-1 What is an opportunity cost? How does the idea relate to the definition of economics? Which of

the following decisions would entail the greatest opportunity cost: Allocating a square block in

the heart of Toronto for a surface parking lot or allocating a square block at the edge of a typical

suburb for such a lot? Explain.

An opportunity cost is what was sacrificed to do or acquire something else. The condition of

scarcity creates opportunity cost. If there was no scarcity, there would be no need to sacrifice one

thing to acquire another.

The opportunity cost would be much higher in Toronto as the alternative uses for that square

block are much more valuable than for a typical suburban city block.

1-2 What is meant by the term “utility” and how does it relate to purposeful behaviour?

“Utility” refers to the pleasure, happiness, or satisfaction gained from engaging in an activity

(eating a meal, attending a ball game, etc.). It is an important component of purposeful behaviour

because people will allocate their scarce time, energy, and money in an attempt to gain the most

utility possible.

1-3 (Key Question) Cite three examples of recent decisions that you made in which you, at least

implicitly, weighed marginal costs and marginal benefits.

Student answers will vary, but may include the decision to come to class, to skip breakfast to get

a few extra minutes of sleep, to attend college or university, or to make a purchase. Marginal

benefits of attending class may include the acquisition of knowledge, participation in discussion,

and better preparation for an upcoming examination. Marginal costs may include lost

opportunities for sleep, meals, or studying for other classes. In evaluating the discussion of

marginal benefits and marginal costs, be careful to watch for sunk costs offered as a rationale for

marginal decisions.

1-4 What are the key elements of the scientific method and how does this method relate to economic

principles and laws?

The key elements include the gathering of data (observation), the formulation of possible

explanations (hypothesis), testing the hypothesis, determining the validity of the hypothesis, and

repeated testing of hypotheses that have appeared to be valid in prior tests.

The scientific method is the technique used by economists to determine economic laws or

principles. These laws or principles are formulated to explain and/or predict behaviour of

individuals or institutions.

1-5 (Key Question) Indicate whether each of the following statements applies to microeconomics or

macroeconomics:

a. The unemployment rate in Canada was 8.0 percent in March 2009.

b. A Canadian software firm discharged 15 workers last month and transferred the

work to India.

c. An unexpected freeze in central Florida reduced the citrus crop and caused the price of

oranges to rise.

d. Canadian output, adjusted for inflation, grew by 0.4 percent in 2008.

e. Last week the Scotia Bank lowered its interest rate on business loans by one-half of 1

percentage point.

f. The consumer price index rose by 2.3 percent in 2008.

Macroeconomics: (a), (d), and (f)

Microeconomics: (b), (c), and (e)

1-6 State (a) a positive economic statement of your choice, and then (b) a normative economic

statement relating to your first statement.

Student answers will vary. Example: (a) The unemployment rate is 4.8 percent; (b) the

unemployment rate is too high. In general we treat “what is” statements as positive, “what should

be” as normative, but keep an eye out for statements like “at full employment an increase in the

production of pizzas should come at the cost of less robots.” Some students may incorrectly

identify the statement as normative because of the term “should.”

1-7 (Key Question) Suppose you won $15 on a Lotto Canada ticket at the local 7-Eleven and

decided to spend all the winnings on candy bars and bags of peanuts. The price of candy bars is

$.75 and the price of peanuts is $1.50.

a. Construct a table showing the alternative combinations of the two products that are

available.

b. Plot the data in your table as a budget line in a graph. What is the slope of the budget

line? What is the opportunity cost of one more candy bar? Of one more bag of peanuts?

Do these opportunity costs rise, fall, or remain constant as each additional unit of the

product is purchased.

c. How, in general, would you decide which of the available combinations of candy bars

and bags of peanuts to buy?

d. Suppose that you had won $30 on your ticket, not $15. Show the $30 budget line in your

diagram. Why would this budget line be preferable to the old one?

(a) Consumption alternatives

Goods A B C D E F

Candy bars 0 4 8 12 16 20

Bags of peanuts 10 8 6 4 2 0

(b)

Candy Bars20

10

Bags of

Peanuts

5.

5.1

75.Slope

The slope for the budget line above, with candy bars on the horizontal axis, is -0.5 (= -

Pcb/Pbp). Note that the figure could also be drawn with bags of peanuts on the horizontal axis.

The slope of that budget line would be -2.

The opportunity cost of one more candy bar is ½ of a bag of peanuts. The opportunity cost of

one more bag of peanuts is 2 candy bars. These opportunity costs are constant. They can be

found by comparing any two of the consumption alternatives for the two goods.

(c) The decision of how much of each to buy would involve weighing the marginal benefits and

marginal costs of the various alternatives. If, for example, the marginal benefits of moving

from alternative C to alternative D are greater than the marginal costs, then this consumer

should move to D (and then compare again with E, and so forth, until MB=MC is attained).

(d)

Candy Bars

B ags ofP eanuts

10

20

20 40

Income = $30

Income = $15

The budget line at $30 would be preferable because it would allow greater consumption of both

goods.

1-8 What are economic resources? What categories do economists use to classify them? Why are

resources also called factors of production? Why are they called inputs?

Economic resources are the natural, human, and manufactured inputs used to produce goods and

services. Economic resources fall into four main categories: labour, land (natural resources), real

capital (machines, factories, buildings, etc.,) and entrepreneurs. Economic resources are also

called factors of production because they are used to produce goods and services. They are

called inputs because they go in to a production process (like ingredients go into a bowl to make a

cake), with the resulting goods and services also being referred to as output.

1-9 Why isn’t money considered a capital resource in economics? Why is entrepreneurial ability

considered a category of economic resources, distinct from labour? What are the major functions

of the entrepreneur?

Money is not considered a capital resource because money is not productive – it provides access

to resources but itself does not directly contribute to the production of goods and services.

Additionally, the quantity of money in circulation does not determine an economy’s productive

capacity, while the amount of capital and other resources does. Doubling the amount of money in

circulation does not change the economy’s physical capacity to produce goods and services.

Money is, however, referred as a financial resource and financial capital, reflecting its ability to

acquire real economic resources.

Entrepreneurial ability and labour are both human resources, but they perform different functions

in the productive process. Entrepreneurial ability does not directly produce goods and services; it

organizes the resources that do. Labour refers to the human inputs that directly engage in

production.

Entrepreneurs are risk-takers: They coordinate the activities of the other three inputs for profit—

or loss, which is why they are called risk-takers. Entrepreneurs sometimes manage companies

that they own, but a manager who is not an owner is not necessarily an entrepreneur but may be

performing some of the entrepreneurial functions for the company. Entrepreneurs are also

innovators, or perhaps inventors, and profits help to motivate such activities.

1-10 (Key Question) Below is a production possibilities table for consumer goods (automobiles) and

capital goods (forklifts):

a. Show these data graphically. Upon what specific assumptions is this production possibilities

curve based?

b. If the economy is at point C, what is the cost of one more automobile? Of one more forklift?

Explain how the production possibilities curve reflects the law of increasing opportunity

costs.

c. If the economy characterized by this production possibilities table and curve were

producing 3 automobiles and 20 fork lifts, what could you conclude about its use of

available resources?

Type of Production Production Alternatives

A B C D E

Automobiles

Forklifts

0

30

2

27

4

21

6

12

8

0

d. What would production at a point outside the production possibilities curve indicate?

What must occur before the economy can attain such a level of production?

(a) See curve EDCBA. The assumptions are full employment, fixed supplies of resources, fixed

technology and two goods.

(b) 4.5 forklifts; .33 automobiles, as determined from the table. Increasing opportunity costs are

reflected in the concave-from-the-origin shape of the curve. This means the economy must

give up larger and larger amounts of rockets to get constant added amounts of automobiles—

and vice versa.

(c) The economy is underutilizing its available resources. The assumption of full employment

has been violated.

(d) Production outside the curve cannot occur (consumption outside the curve could occur

through foreign trade). To produce beyond the current production possibilities curve this

economy must realize an increase in its available resources and/or technology.

.

1-11 (Key Question) Specify and explain the typical shapes of the marginal-benefit and marginal-cost

curves. How are these curves used to determine the optimal allocation of resources to a particular

product? If current output is such that marginal cost exceeds marginal benefit, should more or

fewer resources be allocated to this product? Explain.

The marginal benefit curve is downward sloping, MB falls as more of a product is consumed

because additional units of a good yield less satisfaction than previous units. The marginal cost

curve is upward sloping, MC increases as more of a product is produced since additional units

require the use of increasingly unsuitable resource. The optimal amount of a particular product

occurs where MB equals MC. If MC exceeds MB, fewer resources should be allocated to this

use. The resources are more valuable in some alternative use (as reflected in the higher MC) than

in this use (as reflected in the lower MB).

1-12 Explain how (if at all) each of the following affects the location of a country’s production

possibilities curve:

a. The quality of education increases.

b. The number of unemployed workers increases.

Forklifts

c. A new technique improves the efficiency of extracting iron from ore.

d. A devastating earthquake destroys numerous production facilities.

(a) Assuming better education translates into better work skills, then productivity should rise and

this would shift the curve outward.

(b) Should not affect location of curve. Production moves inward, away from the curve.

(c) The curve should shift outward as more production is possible with existing resources.

(d) The curve should shift inward with the destruction of resources (capital).

1-13 (Key Question) Suppose improvement occurs in the technology of producing forklifts but not in

the technology of producing automobiles. Draw the new production possibilities curve. Now

assume that a technological advance occurs in producing automobiles but not in producing

forklifts. Draw the new production possibilities curve. Now draw a production possibilities

curve that reflects technological improvement in the production of both products.

See the graph for question 1-10. PPC1 shows improved forklift technology. PPC2 shows

improved auto technology. PPC3 shows improved technology in producing both products.

1-14 (Key Question) On average, households in China save 40 percent of their annual income each

year, whereas households in the United States save less than 5 percent. Production possibilities

are growing at roughly 9 percent annually in China and 3.5 percent in Canada. Use graphical

analysis of “present goods” versus “future goods” to explain the differences in growth rates.

Figure 1.6 on page 17 depicts this situation. Canada would be represented by Figure 1.6a

(“Presentville”), producing primarily goods for the present. China’s situation is depicted by

Figure 1.6b (“Futureville”), where emphasis on goods for the future leads to a greater expansion

of production possibilities.

Figure 1.6 is not a perfect representation for a couple of reasons. Both nations are further down

the PPC (i.e. closer to the horizontal axis) than is represented by points “P” and “F.” Also, if

drawn to scale, Canada’s PPC would start further to the right than China’s, even though China’s

would expand more in relative terms.

1-15 Suppose that, on the basis of a nation’s production possibilities curve, an economy must sacrifice

10,000 pizzas domestically to get the 1 additional industrial robot it desires, but that it can get the

robot from another country in exchange for 9,000 pizzas. Relate this information to the following

statement: “Through international specialization and trade, a nation can reduce its opportunity

cost of obtaining goods and thus ‘move outside its production possibilities curve.’”

The message of the production possibilities curve is that an individual nation is limited to the

combinations of output indicated by its production possibilities curve. International

specialization means directing domestic resources to output which a nation is highly efficient at

producing. International trade involves the exchange of these goods for goods produced abroad.

Specialization and trade have the same effect as having more and better resources or discovering

improved production techniques. The output gains from greater international specialization and

trade are the equivalent of economic growth.

(Answer to The Last Word) Studies indicate that married men on average earn more income than

unmarried men of the same age and education level. Why must we be cautious in concluding that

marriage is the cause and higher income is the effect?

Correlation does not necessarily mean that there is causation. The relationship could be purely

coincidental or dependent on some other factor not included in the analysis. It is also possible

that higher income is the variable that “causes” marriage.

Chapter 2 end of chapter key

2-1 Contrast how a market system and a command economy try to cope with economic scarcity.

A market system allows for the private ownership of resources and coordinates economic activity

through market prices. Participants act in their own self-interest and seek to maximize

satisfaction or profit through their own decisions regarding consumption or production. Goods

and services are produced and resources are supplied by whoever is willing to do so. The result is

competition and widely dispersed economic power.

The command economy is characterized by public ownership of nearly all property resources and

economic decisions are made through central planning. The planning board, appointed by the

government determines production goals for each enterprise. The division of output between

capital and consumer goods is centrally decided based on the board’s long-term priorities

2-2 How does self-interest help achieve society’s economic goals? Why is there such a wide variety

of desired goods and services in a market system? In what way are entrepreneurs and businesses

at the helm of the economy but commanded by consumers?

The motive of self-interest gives direction and consistency to the economy. The primary driving

force of the market system is self-interest. Entrepreneurs try to maximize their profits; property

owners want the highest price for their resources; workers choose the job with the best wages,

fringe benefits and working conditions. Consumers apportion their expenditures to maximize

their utility, while seeking the lowest possible prices. As individuals express their free choice, the

economy is directed to produce the most wanted goods at the lowest possible cost.

Each individual consumer will choose a variety of goods and services that in combination will

maximize his/her satisfaction (utility). There is a wide variety because individual wants are

diverse. To maximize profits, producers must respond to the desires of the individual consumer.

Although producers are free to choose what products they will produce, if the producers are to

maximize profits, these good and services must be what consumers desire. Entrepreneurs can

drive the economic ship where they want (at least for a while), but the ship will run aground

(businesses will fail) if entrepreneurs at the helm don’t listen to the consumers that command

them.

2-3 Why are private property, and the protection of property rights, so critical to the success of the

market system?

The ownership of private property and the protection of property rights encourages investment,

innovation, and, therefore, economic growth. Property rights encourage the maintaining of the

property and they facilitate the exchange of the property.

2-4 What are the advantages of using capital in the production process? What is meant by the term

“division of labour”? What are the advantages of specialization in the use of human and material

resources? Explain why exchange is the necessary consequence of specialization.

Capital goods enable producers to operate more efficiently and to produce more output.

“Division of labour” means that workers perform those tasks that are best suited to their

individual abilities and skills.

The advantages of specialization for workers are that they can choose work according to their

natural aptitudes, have the opportunity to perfect those skills, and save time in not having to shift

continually from one task to another. Material resources will be developed and adapted for a

specific use. On a regional basis, each region will produce those products for which it is best

suited. By specializing in its comparative advantage, each region or set of human and material

resources is being used to maximize efficiency.

When resources are specialized, they are no longer self-sufficient. To obtain the goods and

services one needs, exchange is necessary. Also, specialization will result in a surplus of a

specific good being produced. The surplus of one good will be exchanged for the surplus

production of other goods.

2-5 What problem does barter entail? Indicate the economic significance of money as a medium of

exchange. What is meant by the statement: “We want money only to part with it”?

Barter requires the “double coincidence of wants.” If someone wants something, he/she will have

to find someone who wishes to part with that good and at the same time wishes to exchange the

good for something that the first party wishes to part with.

With money as a medium of exchange, one knows the purchase price of the item to be purchased

and it relative price to other items. Money is a very convenient common denominator, a common

measure of value that is also used as a medium of exchange. Money also encourages

specialization. Without money, workers and other resources could not be paid except in the

output produced. All those who participated in the production of the good would have to

collectively exchange it for all the goods and service desired by the resource owners.

Money itself has value only in relation to the resources, goods, and services that can be obtained

with it. When people say that they want money, they really mean that they want the things that

money can buy. In this sense, money imparts value only when someone parts with it.

2-6 Evaluate and explain the following statements:

a. The market system is a profit-and-loss system.

b. Competition is the disciplinarian of the market economy.

(a) The quotation is accurate. In a market system, producer decisions are motivated by the

attempt to earn profits. Those products that enable a firm to earn at least a normal profit

(minimum compensation for the entrepreneur for his/her time and talents) will be produced.

If the product cannot be produced for a profit—in other words, if losses are involved in

production—the capitalist firm will respond by seeking lower cost production methods and

may halt the production of goods completely. Because profits and/or losses are the

motivation behind the fundamental decisions made in a market system, it could be called a

“profit and loss economy.”

(b) Competition provides discipline in two ways. First, it forces firms to seek the least-cost

production methods or face being driven out of business by their rivals. Second, it prevents

successful producers from charging whatever the market will bear. Competition keeps prices

at a level where total revenue will just cover the total cost of production including a normal

profit, but no more in the long run. If sellers try to charge a price that will earn them

economic profits, new firms will enter the industry, increasing supply, and lowering prices

until the economic profits are eliminated. Competition is indispensable in this role, because

otherwise some other method would have to be found to direct firms to use the least-cost

production technique and to charge a price that provides only a normal return. Where

competition does not exist, such as in natural monopolies like public utility companies,

regulators or publicly owned companies must assume the role of disciplinarian. Experience

has shown that this is a difficult process and does not achieve the same results as easily as a

competitive market situation.

2-7 In the 1990s thousands of “dot-com” companies emerged with great fanfare to take advantage of

the Internet and new information technologies. A few, like Yahoo, eBay, and Amazon, generally

thrived and prospered, but many others struggled and eventually failed. Explain these varied

outcomes in terms of how the market system answers the question “What goods and services will

be produced?”

The expectation of economic profits lured many new firms into the “dot-com” industries.

However, because of a lack of information and a market unable to sustain so many firms, many

failed to realize even a normal profit and failed. [Technically many of the early dot-coms were

not earning economic profits, but their shareholders were reaping huge windfalls from the stock

market speculation.] When these new firms found that they could not profitably produce in this

industry, they dropped out and the industry declined. The problem was not so much one of

consumer sovereignty – consumers demonstrated an interest in these services. The heavy

competition of so many firms trying to establish themselves in the market led to prices that were

insufficient to cover economic costs. In a few cases, most notably Napster (an internet company

that allowed uses to download music at little or no cost), government restrictions on activities

(copyright infringement in Napster’s case) led to firm failure (at least for a time).

2-8 (Key Question) With current technology, suppose a firm is producing 400 loaves of banana bread

daily. Also, assume that the least-cost combination of resources in producing those loaves is 5

units of labour, 7 units of land, 2 units of capital, and 1 unit of entrepreneurial ability, selling at

prices of $40, $60, $60, and $20, respectively. If the firm can sell these 400 units at $2 per unit,

will it continue to produce banana bread? If this firm’s situation is typical for the other makers of

banana bread, will resources flow to or away from this bakery good?

The firm will continue to produce as it is earning economic profits of $40 (Total revenue of $800

minus total cost of $760). If this firm is typical, more resources will flow toward banana bread as

other potential firms are attracted to the economic profits.

2-9 (Key Question) Some large hardware stores such as Canadian Tire boast of carrying as many as

20,000 different products in each store. What motivated the producers of those individuals to

make them and offer them for sale? How did producers decide on the best combinations of

resources to use? Who made these resources available, and why? Who decides whether these

particular hardware products should continue to be produced and offered for sale?

The quest for profit led firms to produce these goods. Producers looked for and found the least-

cost combination of resources in producing their output. Resource suppliers, seeking income,

made these resources available. Consumers, through their dollar votes, ultimately decide on what

will continue to be produced.

2-10 What is meant by the term “creative destruction”? How does the emergence of MP3 (iPod)

technology relate to this idea?

Creative destruction refers to the process by which the creation of new products and production

techniques destroys the market positions of firms committed to producing only existing products

or using outdated methods. The ability to download and store a large number of songs, and the

superior quality of MP3 is causing a decline in the CD industry, just as CDs once replaced

cassette tapes, which had previously replaced phonographs (records).

2-11 In a sentence, describe the meaning of the phrase “invisible hand.”

Market prices act as an “invisible hand,” coordinating an economy by rationing what is scarce,

and providing incentives to produce the most desired goods and services.

2-12 In market economies, firms rarely worry about the availability of inputs to produce their products,

whereas in command economies input availability is a constant concern. Why the difference?

In market economies, buyers of inputs know that sellers want to make resources available for sale

because that is how they earn their profits. If there aren’t enough resources available, prices will

rise until suppliers come forth with the desired amounts. In command economies the availability

of inputs depends on what was specified in the plan, and how well the plan was executed. There

is no opportunity (at least not legally) to offer greater payments to get those resources provided.

2-13 Distinguish between the factor market and product market in the circular flow model. In what

way are businesses and households both sellers and buyers in this model? What are the flows in

the circular flow model?

The resource markets are where the owners of the resources (the households) sell their resources

to the buyers of the resources (businesses). In the product markets, businesses sell the goods and

services they have produced to the buyers of the goods and services, the households.

Households (individuals) either own all economic resources directly or own them indirectly

through their ownership of business corporations. These households are willing to sell their

resources to businesses because attractive prices draw them into specific resource markets.

Businesses buy resources because they are necessary for producing goods and services. The

interaction of the buyers and sellers establishes the price of each resource.

In the product market, businesses are the sellers and householders are the buyers; their role in the

market has been reversed. Each group of economic units both buys and sells.

One flow is the flow of real goods and services (including resource services) and the other flow is

the flow of money (money income, consumption expenditures, revenue, production costs).

(Answer to The Last Word) What explains why millions of economic resources tend to get

arranged logically and productively rather than haphazardly and unproductively?

The institution of private property is a primary reason why resources are arranged logically and

productively. Private property eliminates randomness to the allocation of resources, as property

owners act in deliberate ways to protect and maximize the benefits from their property. Owners

pursue the greatest possible returns from their property, drawing resources to their most valued

uses. Through the interaction of millions of economic agents all trying to use their private

property to maximize well-being, a complex, logical, and productive arrangement of resources

results.

Chapter 3 end of chapter key

3-1 Explain the law of demand. Why does a demand curve slope downward? How is a market

demand curve derived from individual demand curves?

As prices change because of a change in supply for a commodity, buyers will change the quantity

they demand of that item. If the price drops, a larger quantity will be demanded. If the price

rises, a lesser quantity will be demanded.

The demand curve slopes downward because of diminishing marginal utility, and the substitution

and income effects. Because successive units of a good provide less additional utility than the

previous units, buyers will only pay for these smaller amounts of utility if the price is lowered.

When the price of a commodity decreases relative to that of substitutes, a buyer will substitute the

now cheaper commodity for those whose prices have not changed. At the same time, the

decreased price of the commodity under discussion will make the buyer wealthier in real terms.

More can be bought of this commodity (as well as of others whose prices have not changed).

Thus, the substitution and income effects reinforce each other: More will be bought of a normal

(or superior) commodity as its price decreases. On a graph with price on the vertical axis and

quantity on the horizontal, this is shown as a demand curve sloping downward from left to right.

The market demand curve is derived by horizontally summing the individual demand curves.

3-2 What are the determinants of demand? What happens to the demand curve when each of these

determinants changes? Distinguish between a change in demand and a change in the quantity

demanded, noting the cause(s) of each.

The fundamental determinant of demand is the price of the commodity under consideration: a

change in price causes movement along the commodity’s demand curve. This movement is

called a change in quantity demanded. Decreased price leads to movement down the demand

curve: There is an increase in quantity demanded. Increased price leads to movement up the

demand curve: There is a decrease in quantity demanded.

In addition, there are determinants of demand, which are factors that may shift the demand curve,

i.e., cause a “change in demand.” These are the number of buyers, the tastes (or desire) of the

buyers for the commodity, the income of the buyers, the changes in price of related commodities

(substitutes and complements), and expectations of the buyers regarding the future price of the

commodity under discussion.

The following will lead to increased demand: more buyers, greater desire for the commodity,

higher incomes (assuming a normal good), lower incomes (assuming an inferior good), an

increased price of substitutes, a decreased price of complements, and an expectation of higher

future prices or incomes. This increased demand will show as a shift of the entire demand curve

to the right.

The reverse of all the above will lead to decreased demand and will show as a shift of the entire

demand curve to the left.

3-3 (Key Question) What effect will each of the following have on the demand for small automobiles

such as the Mini Cooper and Smart car?

a. Small automobiles become more fashionable.

b. The price of large automobiles rises (with the price of small autos remaining the same).

c. Income declines and small autos are an inferior good.

d. Consumers anticipate the price of small autos will greatly come down in the near future.

e. The price of gasoline substantially drops.

Demand increases in (a), (b), and (c); decreases in (d). The last one (e) is ambiguous. As autos

and gas are complements, one could argue that the decrease in gas prices would stimulate demand

for all cars, including small ones. However, one could also argue that small cars are attractive to

consumers because of fuel efficiency, and that a decrease in gas prices effectively reduces the

price of the “gas guzzling” substitutes. That would encourage consumers to switch from smaller

to larger cars (SUVs), and demand for small automobiles would fall. [This presents a good

illustration of the complexity of many of these changes.]

3-4 Explain the law of supply. Why does the supply curve slope upward? How is the market supply

curve derived from the supply curves of individual producers?

As prices rise because of increased demand for a commodity, producers find it more and more

profitable to increase the quantity they offer for sale; that is, the supply curve will slope upward

from left to right. Clearly, firms would rather sell at a higher price than at a lower price.

Moreover, it is necessary for firms to demand a higher price as they increase production. This

comes about because as they produce more and more, they start to run up against capacity

constraints and costs rise. At any given time, a plant has a given size. As production increases,

the firm will need to add an extra shift and then a third shift, both perhaps at higher wages. It

may run out of warehouse space and have to rent at higher cost from another firm. It may have to

pay extra to get increasingly urgent raw material, and so on.

The market supply curve is derived by horizontally adding the individual supply curves.

3-5 What are the determinants of supply? What happens to the supply curve when each of these

determinants changes? Distinguish between a change in supply and a change in the quantity

supplied, noting the cause(s) of each.

The fundamental determinant of supply is the price of the commodity. As price increases, the

quantity supplied increases. An increase in price causes a movement up a given supply curve. A

decrease in price causes a movement down a given supply curve.

The non-price determinants of supply are: resource (input) prices, technology, taxes and

subsidies, prices of other related goods, expectations, and the number of sellers. If one or more of

these change, there will be a change in supply and the whole supply curve will shift to the right or

the left.

The following will cause an increase in supply: a decrease in resource (input) prices; improved

(lower cost) technology; a decrease in business taxes, an increase in subsidies to business; a

decrease in the price of another commodity that this firm was making, provided that commodity

is a substitute in production (the firm can switch from the now lower priced one to our

commodity); an expectation of lower prices in the future; and an increase in the number of sellers.

The increase in supply caused by the noted change in one or more of the above will cause the

entire supply curve to shift to the right. More will now be supplied at any given price.

Alternatively expressed, any given amount will now be supplied at a lower price.

The reverse of any or all the above changes in the determinants of demand will cause a decrease

in demand and will be shown as a shift of the supply curve to the left. Less will now be supplied

at any given price. Alternatively expressed, any given amount will now be supplied at a higher

price.

3-6 (Key Question) What effect will each of the following have on the supply of automobile tires?

a. A technological advance in the methods of producing tires.

b. A decline in the number of firms in the tire industry.

c. An increase in the price of rubber used in the production of tires.

d. The expectation that the equilibrium price of auto tires will be lower in the future than it is

currently.

e. A decline in the price of large tires used for semi-trucks and earth hauling rigs (with no

change in the price of auto tires).

f. The levying of a per-unit tax in each auto tire sold.

g. The granting of a 50-cent-per-unit subsidy for each auto tire produced.

Supply increases in (a), (d), (e), and (g); decreases in (b), (c), and (f).

3-7 “In the corn market, demand often exceeds supply and supply sometimes exceeds demand.” “The

price of corn rises and falls in response to changes in supply and demand.” In which of these two

statements are the terms “supply” and “demand” used correctly? Explain.

In the first statement “supply” and “demand” are used incorrectly. Supply and demand are both

schedules or curves that intersect where quantity supplied and quantity demanded are equal. One

cannot talk of curves that intersect as exceeding or not exceeding each other.

Supply and/or demand can change (the entire curves can shift). Each time this happens, it will

create a new intersection of the two curves that will lead to changes in the equilibrium quantity

and price of corn. Thus, the terms “supply” and “demand” are used correctly in the second

statement.

3-8 (Key Question) Suppose the total demand for wheat and the total supply of wheat per month in

the Kansas City grain market are as follows:

Thousands

of bushels

demanded

Price

per

bushel

Thousand

of bushels

supplied

Surplus (+)

or

shortage (-) 85

80

75

70

65

60

$3.40

3.70

4.00

4.30

4.60

4.90

72

73

75

77

79

81

_____

_____

_____

_____

_____

_____

a. What is the equilibrium price? What is the equilibrium quantity? Fill in the surplus-shortage

column and use it to explain why your answers are correct.

b. Graph the demand for wheat and the supply of wheat. Be sure to label the axes of your graph

correctly. Label equilibrium price P and the equilibrium quantity Q.

c. Why will $3.40 not be the equilibrium price in this market? Why not $4.90? “Surpluses drive

prices up; shortages drive them down.” Do you agree?

Data from top to bottom: -13; -7; 0; +7; +14; and +21.

(a) Pe = $4.00; Qe = 75,000. Equilibrium occurs where there is neither a shortage nor surplus of

wheat. At the immediately lower price of $3.70, there is a shortage of 7,000 bushels. At the

immediately higher price of $4.30, there is a surplus of 7,000 bushels. (See graph above).

(b) See graph above.

(c) Because at $3.40 there will be a 13,000 bushel shortage which will drive price up. Because at

$4.90 there will be a 21,000 bushel surplus which will drive the price down. Quotation is

incorrect; just the opposite is true.

3-9 (Key Question) How will each of the following changes in demand and/or supply affect

equilibrium price and equilibrium quantity in a competitive market; that is do price and quantity

rise, fall, remain unchanged, or are the answers indeterminate because they depend on the

magnitudes of the shifts? Use supply and demand diagrams to verify your answers.

a. Supply decreases and demand is constant.

b. Demand decreases and supply is constant.

c. Supply increases and demand is constant.

d. Demand increases and supply increases.

e. Demand increases and supply is constant.

f. Supply increases and demand decreases.

g. Demand increases and supply decreases.

h. Demand decreases and supply decreases.

(a) Price up; quantity down;

(b) Price down; quantity down;

(c) Price down; quantity up;

(d) Price indeterminate; quantity up;

(e) Price up; quantity up;

(f) Price down; quantity indeterminate;

(g) Price up, quantity indeterminate;

(h) Price indeterminate and quantity down.

3-10 In 2001 an outbreak of foot-and-mouth disease in Europe led to the burning of millions of cattle

carcasses. What impact do you think this had on the supply of cattle hides, hide prices, the

supply of leather goods, and the price of leather goods? In 2004, millions of chickens were culled

in British Columbia due to the avian flu. What impact do you think this had on the supply of

eggs, and the price of eggs?

The supply of cattle hides was reduced, raising the price of hides. Because hides were more

expensive, it became more costly to produce leather, reducing the supply and raising the price of

leather goods. Millions of chicken culled resulted in higher egg prices.

3-11 Critically evaluate: “In comparing the two equilibrium positions in Figure 3.7b, I note that a

smaller amount is actually demanded at a lower price. This refutes the law of demand.”

The key point here is that the second equilibrium occurs after demand has decreased, that is

demand has shifted because of a change in determinants, which has caused buyers to want less at

every price compared to the original D1 demand curve and schedule. Each equilibrium price

refers to a different demand situation. Therefore, the fact that less is purchased at a lower price

when demand decreases does not refute the law of demand. Note that on the second demand

curve and schedule, less would still be purchased at a higher price.

3-12 For each stock in the stock market, the number of shares sold daily equals the number of shares

purchased. That is, the quantity of each firm’s shares demanded equals the quantity supplied. So,

if this equality always occurs, why do the prices of stock shares ever change?

During any given stock trading session, there will be both prospective buyers and sellers, each

willing to buy or sell a certain number of shares depending on price. If at the current price (e.g.

the day’s opening price) the quantity of shares demanded exceeds the quantity of shares supplied,

buyers must increase their price offers to induce sellers to offer enough shares. This will cause

share prices to rise until quantity demanded equals quantity supplied. Suppose that during the

trading session there is a report of bad economic news. Sellers may respond by trying to sell

more shares than buyers are wanting at the current price. In order to find enough willing buyers,

sellers will have to offer their shares at lower prices. On any given trading day, there will be

multiple equilibrium prices, many of them not lasting for more than a few minutes (or even

seconds).

3-13 Using the schedules given, plot the demand curve and the supply curve on the below graph.

Label the axes and indicate for each axis the units being used to measure price and quantity.

Then answer the questions.

Price

Quantity demanded (bushels of wheat)

Price

Quantity supplied (bushels of wheat)

$4.20 125,000 $4.20 230,000

4.00 150,000 4.00 220,000

3.80 175,000 3.80 210,000

3.60 200,000 3.60 200,000

3.40 225,000 3.40 190,000

3.20 250,000 3.20 180,000

3.00 275,000 3.00 170,000

(a) Give the equilibrium price and quantity for wheat.

(b) Indicate the equilibrium price and quantity on a graph by drawing lines from the intersection

of the supply and demand curves to the price and quantity axes.

(c) If the federal government decided to support the price of wheat at $4.00 per bushel, tell

whether there would be a surplus or shortage and how much it would be.

(d) Demonstrate your answer to part (c) on your graph being sure to label the quantity you

designated as the shortage or surplus.

(a) The equilibrium price and quantity for wheat will be $3.60 and 200,000 bushels.

(b) The equilibrium price and quantity on the graph are labelled Pe and Qe.

(c) If the federal government decided to support the price of wheat at $4.00 per bushel, there

would be a surplus of 220,000 – 150,000 = 70,000 bushels.

(d) See surplus labelled on figure.

3-14 (Key Question) Refer to the table in question 8. Suppose that the government establishes a price

ceiling of $3.70 for wheat. What might prompt the government to establish this price ceiling?

Explain carefully the main effects. Demonstrate your answer graphically. Next, suppose that the

government establishes a price floor of $4.60 for wheat. What will be the main effects of this

price floor? Demonstrate your answer graphically.

At a price of $3.70, buyers will wish to purchase 80,000 bushels, but sellers will only offer

73,000 bushels to the market. The result is a shortage of 7,000 bushels. The ceiling prevents the

price from rising to encourage greater production, discourage consumption, and relieve the

shortage. See the graph below.

At a price of $4.60, buyers only want to purchase 65,000 bushels, but sellers want to sell 79,000

bushels, resulting in a surplus of 14,000 bushels. The floor prevents the price from falling to

eliminate the surplus. See the graph below.

3-15 What do economists mean when they say that “price floors and ceilings stifle the rationing

function of prices and distort resource allocation”?

When unrestrained, prices rise and fall to correct imbalances between the quantity supplied and

quantity demanded in a market. If sellers find themselves at a given price with more output than

consumers are willing to purchase, the price will fall. Likewise, if the market is not offering

enough of a good to satisfy consumer demand, the price will rise. Price floors and ceilings

prevent price movements to correct these imbalances. When a price is set above equilibrium (i.e.

a price floor), sellers will produce more than the market can support, diverting resources away

from more highly valued uses. Price ceilings result in an underallocation of resources toward a

particular good, where the excess demand (shortage) reveals that consumers value the good (and

therefore the resources used to produce it) more than what the market currently offers

3-16 Use data in the following table to explain the economic effects of a price ceiling at $6, at $5, and

at $4.

Quantity Quantity

Price demanded supplied

$7 4,500 4,500

6 5,000 3,500

5 5,500 2,500

4 6,000 1,500

A price ceiling means that the price will not be permitted to rise above a maximum price. If the

price ceiling is below the competitive equilibrium price of $7, it would produce a shortage of

the product. For example, if the price ceiling was set at $6, the quantity demanded would be

5,000 units and the quantity supplied would be 3,500 for a shortage of 1,500 units. With a

price ceiling set at $5, the shortage would be 3,000 units, and with a price ceiling of $4, the

shortage would be 4,500 units. A price ceiling interferes with the rationing function of price

that serves to balance the decisions of demanders and suppliers. The price ceiling produces a

shortage that indicates that resources are being underallocated; output is not being produced

because some producers cannot make a profit at the price ceiling level.

3-17 Use data in the following table to explain the economic effects of a price floor at $8, at $9, and

at $10. Explain the economic effects.

Quantity Quantity

Price demanded supplied

$10 3,000 7,500

9 3,500 6,500

8 4,000 5,500

7 4,500 4,500

A price floor means that the price is not allowed to fall below a minimum price set by

government. If the price floor is above the competitive equilibrium price of $7, a surplus of the

product would result. If the price floor was set at $8, the quantity demanded would be 4,000

units but the quantity supplied would be 5,500 units for a surplus of 1,500 units. At a price

floor of $9, the surplus would be 3,000 units, and with a price floor of $10, the surplus would

be 4,500 units. A price floor interferes with the rationing function of price that serves to

balance the decisions of suppliers and demanders. The price floor that produces a surplus

indicates that resources are being overallocated and that there is economic inefficiency; output

is being produced which consumers do not want to purchase at the price floor.

3-18 Advanced analysis: Assume that the demand for a commodity is represented by the equation P =

10 - .2Qd and supply by the equation P = 2 + .2Qs, where Qd and Qs are quantity demanded and

quantity supplied, respectively, and P is price. Using the equilibrium condition Qs = Qd, solve

the equations to determine equilibrium price. Now determine equilibrium quantity. Graph the

two equations to substantiate your answers.

Demand is P = 10 – 2Qd

Therefore 5P = 50 – Qd = 50 – 5P

Supply is P = 2 + 2Qs

Therefore 5P = 10 + Qs and Qs = –10 + 5P

Substitute Qd and Qs into Qs = Qd equilibrium condition

50 – 5P = –10 + 5P

60 = 10P and 6 = P

Now substitute P = 6 in either Qd or Qs to determine equilibrium quantity

Qd = 50 – 5P = 50 – 5(6) = 20

or

Qs = –10 + 5P = –10 + 5(6) = 20

(Answer to the Last Word) How many organ transplants were done in Canada in the latest year

for which statistics are available? What is the current overall number of candidates waiting for an

organ transplant? (For the answer, visit the London Health Science Centre Web site,

http://www.lhsc.on.ca/transplant/overview.htm.) Do you favour the establishment of a legal

market for transplant organs? Why or why not?

More than 4,000 Canadians are waiting for an organ transplant to save or improve their lives. In

2007, only 2,188 transplants were performed, so many patients remain on the waiting list.

Answers to the other questions will vary.

Chapter 4 end of chapter key

4-1 Explain why the choice between 1, 2, 3, 4, 5, 6, 7, and 8 “units” or 1000, 2000, 3000, 4000, 5000,

6000, 7000, and 8000 movie tickets, makes no difference in determining elasticity in Table 4-1.

Price elasticity of demand is determined by comparing the percentage change in price and the

percentage change in quantity demanded. The percentage change in quantity will remain the

same regardless of whether the difference is between 1 unit and 2 units or 1000 units and 2000

units.

4-2 (Key Question) Graph the accompanying demand data and then use the midpoints formula for Ed

to determine price elasticity of demand for each of the four possible $1 price changes. What can

you conclude about the relationship between the slope of a curve and its elasticity? Explain in a

0

2

4

6

8

10

12

14

0 20 40 60

Pri

ce

Quantity

Question 3-18

Supply

Demand

non-technical way why demand is elastic in the northwest segment of the demand curve and

inelastic in the southeast segment.

Product

price

Quantity

demanded

$5

4

3

2

1

1

2

3

4

5

See the graph accompanying the answer to 4-4. Elasticities, top to bottom: 3; 1.4; .714; .333.

Slope does not measure elasticity. This demand curve has a constant slope of -1 (= -1/1), but

elasticity declines as we move down the curve. When the initial price is high and initial quantity

is low, a unit change in price is a low percentage while a unit change in quantity is a high

percentage change. The percentage change in quantity exceeds the percentage change in price,

making demand elastic. When the initial price is low and initial quantity is high, a unit change in

price is a high percentage change while a unit change in quantity is a low percentage change. The

percentage change in quantity is less than the percentage change in price, making demand

inelastic.

4-3 The following data shows the relationship between price and quantity demanded at four

different prices for a product:

P = $11, Qd = 16

P = $9, Qd = 24

P = $7, Qd = 32

P = $5, Qd = 40

Using the midpoints formula, what is the price elasticity of demand between: (a) $11 and $9;

(b) $9 and $7; (c) $7 and $5?

(a) 2.0; (b) 1.14; (c) 0.67

4-4 (Key Question) Calculate total-revenue data from the demand schedule in question 2. Graph total

revenue below your demand curve. Generalize on the relationship between price elasticity and

total revenue.

See the graph. Total revenue data, top to bottom: $5; $8; $9; $8; $5. When demand is elastic,

price and total revenue move in the opposite direction. When demand is inelastic, price and total

revenue move in the same direction.

Question 4-4

4-5 (Key Question) How would the following changes in price affect total revenue. That is, would

total revenue increase, decline, or remain unchanged?

a. Price falls and demand is inelastic.

b. Price rises and demand is elastic.

c. Price rises and supply is elastic.

d. Price rises and supply is inelastic.

e. Price rises and demand is inelastic.

f. Price falls and demand is elastic.

g. Price falls and demand is of unit elasticity.

Total revenue would increase in (c), (d), (e), and (f); decrease in (a) and (b); and remain the same

in (g).

4-6 The president of the Micro Brewing Corporation asks you, as the company economist, to

forecast changes in consumer beer purchases associated with a proposed price change. You

conduct a survey and find that if the price of a six-pack increases from $5.50 to $7.50, the

quantity demanded will decrease from 2,200 units to 1,800 units a month. Should the Micro

Brewing Corporation raise its price? Explain the economic basis for this recommendation to the

president.

Yes, the corporation should increase the price of a six-pack. Over the price range considered, the

price elasticity of demand coefficient is 0.65, or inelastic, using the midpoints formula. An

increase in price when demand is inelastic will increase total revenue. This increase in total

revenue also can be shown by multiplication. With a price of $5.50 times a quantity of 2,200 per

month, the total revenue was $12,100. With the higher price of $7.50 times a lower quantity of

1,800, the total revenue is $13,500. Thus, there is a gain of $1,400 in total revenue from raising

the price.

4-7 The following is a straight-line demand curve that confronts a single firm.

Quantity

Price demanded (3) (4)

$6 1 _____ _____

5 2 _____ _____

4 3 _____ _____

3 4 _____ _____

2 5 _____ _____

1 6 _____ _____

(a) In column 3, compute total revenue. In column 4, compute the coefficient for the price

elasticity of demand at each price using the midpoints formula.

(b) Describe the character of elasticity across the prices based on the total revenue test and the

elasticity coefficient.

(c) Does a straight-line demand curve have constant elasticity?

(d) Of what practical significance is your answer to (c)?

Quantity

Price demanded (3) (4)

$6 1 $6

3.7

5 2 10

1.8

4 3 12

1.0

3 4 12

0.6

2 5 10

0.3

1 6 6

(a) See the above table for the answers.

(b) Total revenue declines when price drops from $3 to $2, and the elasticity coefficient also

becomes less than 1 at that price change. Demand is elastic in the range of prices between $6

and $4, and inelastic below $3. A drop in price from $4 to $3 illustrates unitary elasticity.

(c) The clear answer is “no” based on the answers in the table. Although the slope of a linear

demand curve is, by definition, constant, elasticity varies because it measures percentage

changes.

(d) The significance is twofold. (1) One cannot tell elasticity by looking at a demand curve

because the elasticity changes over the range of the curve. (2) The elasticity of demand for any

product will depend on the level of its initial price and quantity, not just on the change in price.

Therefore, the demand for a product may be very elastic in one price range (generally the higher

price ranges) and very inelastic in another (lower) price range

4-8 (Key Question) What are the major determinants of price elasticity of demand? Use these

determinants and your own reasoning in judging whether demand for each of the following

products is elastic or inelastic:

(a) bottled water, (b) tooth paste; (c) Crest toothpaste; (d) ketchup, (e) diamond bracelets; (f)

Microsoft Windows operating system.

Substitutability, proportion of income; luxury versus necessity, and time. Elastic: (a), (c), (e).

Inelastic: (b), (d), and (f).

4-9 What effect would a rule stating that university students must live in university dormitories have

on the price elasticity of demand for dormitory space? What impact might this in turn have on

room rates?

The ruling would make the price elasticity of demand more inelastic than if there were no such

rule, assuming that there is not another equivalent university nearby to which students could

transfer. Although universities are non-profit organizations, the rule would certainly allow them

to raise rates without worrying so much about students moving out to live elsewhere.

4-10 In November 1998 Vincent van Gogh’s self-portrait sold at auction for $71.5 million. Portray

this sale in a demand and supply diagram and comment on the elasticity of supply. Comedian

George Carlin once mused, “If a painting can be forged well enough to fool some experts, why is

the original so valuable?” Provide an answer.

The supply is perfectly inelastic—vertical—at a quantity of 1 unit. The $71.5 million price is

determined where the downward sloping demand curve intersected this supply curve.

If more than one picture where available (all but one having to be a copy), the demand would

likely decrease enormously.

4-11 (Key Question) What is the formula for measuring the price elasticity of supply? Suppose the

price of apples goes up from $20 to $22 a box. In direct response, Goldsboro Farms supplies

1200 boxes of apples instead of 1000 boxes. Compute the coefficient of price elasticity

(midpoints approach) for Goldsboro’s supply. It its supply elastic, or is it inelastic?

Es = percentage change in quantity supplied / percentage change in price.

Using the midpoint formula, Es = 1.91 {= (200/[(1000+1200)/2] / 2/[(20+22)/2]}

Supply is price elastic (Es>1).

4-12 Explain the perspective that tougher enforcement of drug laws for cocaine or other drug laws may

actually increase the crime rate. Use the concepts of demand, supply, and elasticity in your

explanation.

Tougher enforcement of drug laws reduces the supply of cocaine and other illegal drugs, thus

driving up the street price. The demand for cocaine and other drugs, however, appears to be

highly inelastic. The increased price will increase total revenues and profits for sellers, but at the

same time it will increase total spending by drug users. To support this increased spending, drug

users are likely to commit more crimes. Thus, the increased enforcement of drug laws may have

the secondary effect of increasing money-producing crimes such as robbery, burglary, shoplifting,

and fraud.

4-13 A computer company is considering lowering the price of its laptop computer to promote sales.

However, it worries that this will reduce desktop computer sales. It finds the cross product of

demand to be 1.5. Are its concerns legitimate? Explain.

Yes. A cross elasticity of demand of 1.5 indicates that there is a positive relationship between the

sales of desktop computers and the change in price of laptop computers, implying that they are

substitutes. This means that when the price of laptop computers falls, sales for desktop

computers also fall as consumers switch over and buy laptop computers. Thus, the computer

company will have to consider how much it’s willing to let desktop computer sales drop to

increase sales of laptop computers, and if that would be profitable.

4-14 (Key Question) Suppose the cross elasticity of demand for products A and B is +3.6 and for

products C and D it is -5.4. What can you conclude about how products A and B are related?

Products C and D?

A and B are substitutes; C and D are complements.

4-15 Use the information in the table below to identify the type of cross elasticity relationship

between products X and Y in each of the following five cases, A to E.

Cases

Percent change in price of Y

Percent change in quantity demanded of X

Cross elasticity type

A 5 7 __________

B 9 6 __________

C 5 –5 __________

D 3 0 __________

E –2 10 __________

Cases

Percent change in price of Y

Percent change in quantity demanded of X

Cross elasticity type

A 5 7 substitute

B 9 6 substitute

C 5 –5 complement

D 3 0 independent

E –2 10 complement

4-16 (Key Question) The income elasticities of demand for movies, dental services, and clothing have

been estimated to be +3.4, +1.0, and +0.5 respectively. Interpret these coefficients. What does it

mean if the income elasticity coefficient is negative?

All are normal goods—income and quantity demanded move in the same direction. These

coefficients reveal that a 1 percent increase in income will increase the quantity of movies

demanded by 3.4 percent, of dental services by 1.0 percent, and of clothing by 0.5 percent. A

negative coefficient indicates an inferior good—income and quantity demanded move in the

opposite direction.

4-17 Research has found that an increase in the price of beer would reduce the amount of marijuana

consumed. Is cross elasticity between the two products positive or negative? Are these products

substitutes or complements? What might be the logic behind this relationship?

The cross elasticity of the two products is negative. The products appear to be complementary.

As one drinks beer, one also smokes marijuana.

4-18 (Key Question) What is the incidence of a tax when demand is highly inelastic? Elastic? What

effect does the elasticity have on the incidence of a tax?

The incidence of a tax is likely to be primarily on consumers when demand is highly inelastic and

primarily on producers when demand is elastic. The more elastic the supply, the greater the

incidence of an excise tax on consumers and less on producers.

4-19 Refer to Table 4.5. If the six people listed in the table are the only consumers in the market and

the equilibrium price is $11 (not the $8 shown), how much consumer surplus will the market

generate?

The total consumer surplus will be $3 ($2 for Bob, $1 for Barb, $0 for Bill, and Bart, Brent, and

Jenny will not purchase the good at a price of $11).

4-20 Refer to Table 4.6. If the six people listed in the table are the only producers in the market and

the equilibrium price is $6 (not the $8 shown), how much producer surplus will the market

generate?

The total producer surplus will be $6 ($3 for Carlos, $2 for Courtney, $1 for Chuck, $0 for

Cindy, and Craig and Chad will not sell at a price of $6).

4-21 Draw a supply and demand graph and identify the areas of consumer and producer surplus.

Given the demand curve, what impact will an increase in supply have on the amount of consumer

surplus shown in your diagram? Explain why.

The graph will look like Figure 4-11 in the chapter. An increase in supply will lower the price

and increase the amount of consumer surplus for a given demand curve. Any individual that was

receiving consumer surplus before the change in supply will realize an increase in consumer

surplus as the price falls and the difference between their maximum willingness to pay and the

market price widens.

4-22 (Key Question) Use the ideas of consumer surplus and producer surplus to explain why

economists say competitive markets are efficient. Why are below- or above-equilibrium levels of

output inefficient, according to these two sets of ideas?

When the consumers’ utility exceeds the price paid, consumer surplus is generated. Likewise,

when producers receive a price greater than marginal cost, producer surplus is created. By

producing up to the point where MB = MC, the maximum potential consumer surplus and

producer surplus is generated. Producing less than the equilibrium level means that potential

surplus is left unrealized. Overproduction subtracts from the surplus because society values the

use of the additional resources in other pursuits more than it values them in consumption of that

good.

(Answer to The Last Word) What is the purpose of charging different groups of customers

different prices? Supplement the three broad examples in the Last Word with two additional

examples of your own. Hint: Think of price discounts based on group characteristic or time of

purchase.

The primary purpose for charging different prices is to increase revenue and, in turn, profits.

Other examples include student and senior citizen discounts (group characteristics based on age

or activity), and movies and golf courses (discounts for consumption during “off-peak” times in

order to spread out consumption and increase revenue).